May 21 (Bloomberg) -- Use of the Federal Reserve’s reverse
repurchase agreement facility is surging as speculation rises
that policy makers may make the program a permanent tool to be
used during the unwinding of unprecedented monetary stimulus.

Daily usage has averaged $194 billion a day in May,
compared with $86 billion in the first three months of the year
and $11.8 billion on Sept. 23, the day the Fed began testing the
fixed-rate facility. Minutes released today of the Fed’s April
30 meeting showed policy makers heard a staff presentation on
how to control short-term interest rates that included the
overnight repo agreements.

The program lets banks, broker-dealers, money-market funds
and some government-sponsored enterprises lend the Fed cash
overnight at a fixed rate, currently 0.05 percent, in exchange
for borrowing Treasuries in so-called reverse repo transactions.
In a reverse repo, the Fed lends securities for a set period,
temporarily draining cash from the banking system. At maturity,
the securities are returned to the Fed, and the cash to its
counterparties.

“It’s not necessarily a bad thing that the Fed’s presence
in money markets has increased,” Brian Smedley, an interest-rate strategist at Bank of America Corp. in New York, said in a
telephone interview on May 19. “The Fed has always been the
dominant factor in determining the general level of overnight
rates; in the pre-crisis era they were managing the Fed
effective rate through their open market operations.”

Daily Allotment

The program has helped put a floor under money-market
rates, which may otherwise have slide toward zero given a
seasonal shortage of bills and heightened safe-haven demand,
according to Barclays Plc. The allure of the facility has risen
as investors face limited Treasury bills supply and regulatory
pressures increasing the need for the safest of debt.

The per-counterparty daily allotment cap is currently set
at $10 billion, up from $500 million when the program began in
September. At full capacity, these limits would be removed,
according to minutes from the July 2013 meeting of the Fed.

The facility “allows us to make a short-term safe asset
more widely available to a broad range of financial market
participants,” New York Fed President William Dudley said
yesterday in remarks before New York Association for Business
Economics.

Federal Bank of San Francisco President John Williams told
reporters on May 19 following a panel discussion in Dallas that
the overnight fixed-rate reverse repurchase program “should be
part of our toolkit” as the Fed begins raising interest rates.

The Federal Open Market Committee, which is buying bonds to
hold down long-term interest rates and spur growth, last month
announced plans to cut monthly asset purchases by $10 billion,
to $45 billion.

Exit Strategy

“We believe it is too early to expect updates on the Fed’s
exit strategy and on how it will approach normalizing policy,”
wrote David Keeble, the New York-based head of fixed-income
strategy at Credit Agricole SA, in note published on May 16.
“However, we expect it to be revised eventually to take into
account the role of the reverse repo facility.”

Prior to the financial crisis, the Fed would add or drain
reserves from the banking system through its temporary open
market operations as means to guide its target rate up or down.
The Fed sought to keep its effective rate, a volume-weighted
average on trades in overnight funds, in line with their target.

Supply of high-quality, short-term debt, is falling at the
same time as a heightened regulatory environment boosts the need
for the debt. The Treasury has cut sales of short-term debt as
it pushed to lock in record low rates over the longer term.
Treasury data shows bills now account for just 12.1 percentage
of total marketable debt, is the lowest since 1953, according to
Barclays.

Daily Financing

The Fed’s agreements have also gained in allure as yields
on alternative debt has fall in line with the fixed reverse repo
rate and as dealers pull back from the repo market as they shore
up balance sheet. The general collateral finance repo rate for
Treasuries averaged 0.056 percent yesterday, according to the
DTCC GCF Treasury Repo index.

The amount of daily securities financed in the tri-party
repo market was $1.52 trillion as of April 9, Fed data show.
That’s down from a peak of more than $2.8 trillion a day on
average in 2008.

Some market participants, as well as the Fed’s Dudley, do
see potential risk of the reverse repo program, including the
growing ’’footprint’’ the central bank has in the money market,
according to the New York Fed president.

Program Risks

If the facility grew excessively and had a rate close to
that the central bank offers on excess reserves, now 0.25
percent, it “might result in a large amount of dis-intermediation out of banks through money market funds and other
financial intermediaries into the facility.”

Deborah Cunningham, the head of money-market funds at
Pittsburgh-based Federated Investors Inc., the fourth-largest
U.S. money fund manager, said they are still maintaining
relationships with a wide array of repo counterparties given
these risks.

“You’ve already have banks and other players exiting the
traditional repo marketplace,” Cunningham said in a telephone
interview yesterday. “Two years from now, when the Fed’s
balance sheet is only half the size and they decide the program
is not as an important feature as it used to be, does that leave
most of us that are still reliant on the liquidity in the
overnight traditional repo marketplace without a provider or
with a lack of diversification?”